Why You Should Be Cautious About Homebuilders

In the fourth-quarter results it released earlier today, homebuilder Lennar beat consensus forecasts. In the past few days, homebuilders such as Toll Brothers and Hovnanian Enterprises have also reported strong quarterly results, indicating that the housing market recovery remains on track. But despite this robust financial performance, investors may still want to be cautious about homebuilders heading into 2014.

Quarterly results encouragingLennar reported its financial results for the fourth quarter ended Nov. 30, 2013, posting net earnings of $0.73 per share, up from $0.56 per share year over year. Lennar's backlog for the quarter rose 19%, while the dollar value of that backlog increased 40%. Revenue for the quarter rose 42%.

Describing fiscal 2013 as an excellent year, CEO Stuart Miller said that revenues and pre-tax earnings attributable to Lennar increased 45% and 170%, respectively, in the fiscal year. Not surprisingly, Lennar shares were up sharply in early trading on Wednesday as investors cheered that strong performance.

Lennar's results came shortly after Toll Brothers reported better-than-expected fourth-quarter earnings. Toll Brothers' backlog rose 57% in dollar terms and 43% in units terms in the quarter. l Hovnanian Enterprises also reported better-than-expected earnings in its fourth quarter. In fact, Hovnanian gave a very upbeat outlook for the housing market following the release of its quarterly results. CEO Ara Hovnanian said that he believes that household formations will ultimately lead to increased demand for new homes, and that the industry is still in the early stages of recovery.

Based on these assessments, one would expect to be bullish on homebuilders entering into 2014. However, I believe homebuilders face great deal of uncertainty, mainly thanks to speculation over the Federal Reserve's bond purchases.

A disappointing year after strong performance in 20122012 was an excellent year for most homebuilders, as a rebound in the housing market boosted the sector's appeal. The improvement in the housing market was driven mainly by significant pent-up demand and ultra-loose monetary policy measures from the Federal Reserve.

After the Fed announced QE3 in September 2012, mortgage rates in the U.S. fell to record low levels, further aiding the recovery and boosting the financial performance of homebuilders such as Lennar.

However, 2013 has turned out to be a mixed year for homebuilders. While the housing market recovery has continued, the performance of homebuilders' shares has been disappointing. As I said earlier, Lennar shares have fallen about 9% so far this year. Others such as Toll Brothers and Hovnanian Enterprises have also disappointed, amid investors' concerns over rising mortgage rates.

After hovering near record low levels, mortgage rates began rising in May this year, following speculation that the improving economy might prompt the Fed to start easing its bond purchases and eventually end QE3 by 2014. In turn, investors began to fear that those rising rates would derail the nascent housing recovery.

While I don't think that will happen, the pace of recovery could definitely slow down in 2014. Dec. 18 data from the Mortgage Bankers Association showed that a slight increase in interest rates had driven mortgage applications to drop 5.5% in the previous week, to their lowest level in more than 12 years.

Those rising rates owe mainly to speculation that the Federal Reserve will start easing its bond purchases. Indeed, the Fed just announced that it will begin trimming $10 billion from its monthly bond purchases in January.

On the sidelinesThe Fed's decision to taper early next year creates a deal of uncertainty for homebuilders. Keen an eye out to see how sharply mortgage rates rise; a steep climb could hurt homebuilders in 2014. Until you know for certain how tapering will affect those rates, a little caution might serve you well.